The Reserve Bank of India (RBI) in its latest report on Currency and Finance (RCF) for 2020-21 has said the current numerical framework to define price stability -- an inflation target of 4 per cent with a +/-2 per cent tolerance band -- is appropriate for the next five years. It also said the focus of flexible inflation targeting (FIT) on price stability augurs well for further liberalisation of the capital account to globalise Indian rupee.
The report "Reviewing the Monetary Policy Framework" assumes topical relevance in the context of the review of the inflation target by March 2021 , against the backdrop of structural changes in the macroeconomic and financial landscape, the RBI said.
The study period in this report is from October 2016 to March 2020, commencing with the formal operationalisation of the flexible inflation targeting (FIT) framework, though it excluded the COVID-19 pandemic time in view of data distortions.
As per the RBI, during the period under review, the headline CPI inflation averaged 3.9 per cent in India with a decline in inflation volatility, which shows the success of FIT in terms of its primary mandate.
The central bank said the 4 per cent inflation benchmark is appropriate for India. "Trend inflation to which actual inflation converges after a shock provides an appropriate benchmark for the inflation target; trend inflation has fallen from above 9 per cent before FIT to a range of 3.8-4.3 per cent during FIT, indicating that 4 per cent is the appropriate level of the inflation target for India," the RBI report said.
As per the apex bank, the threshold inflation above which growth is unambiguously impaired ranges between 5 and 6 per cent in India, which shows an inflation rate of 6 per cent is the appropriate upper tolerance limit.
On the other hand, a lower bound above 2 per cent can lead to actual inflation frequently dipping below the tolerance band and a lower bound below 2 per cent will hamper growth. This also shows that an inflation rate of 2 per cent is the appropriate lower tolerance bound.
The RBI also said the institutional architecture of FIT in India, including the size of the monetary policy committee (MPC) and its composition, decision making, communication practices and accountability mechanisms is in line with international best practices.
But, it said there's a need to review the definition of the time horizon of failure, processes of onboarding of MPC members, some aspects of forward guidance and timings relating to release of minutes, shut periods and release of transcripts.
The RBI said during the FIT period, monetary transmission has been full and reasonably swift across the money market but less than complete in the bond markets.
"While there has been an improvement in transmission to lending and deposit rates of banks, external benchmarks across all categories of loans and deposits could improve transmission further," it said.
The RBI said in the conduct of monetary policy in an open economy setting, foreign exchange reserves and associated liquidity management are the key. So, there is a need to enhance the RBI's sterilisation capacity to deal with surges in capital flows, it said.